Coco Robicheaux was working his bluesy mojo down by the Mississippi Riverwalk. Iced tea in one hand, digital recorder in the other, I had come home to New Orleans on this fine spring day to report on a piece of good news: Louisiana had just become the No. 3 film-producing state in the nation, behind only California and New York. Direct spending on film, TV, and music-video production rose from $12 million in 2002 to more than $1 billion projected for 2007, and the state has played host to Oscar bait such as Ray and All the King's Men, as well as big-budget action flicks such as Déjà Vu and The Guardian. Even Katrina didn't halt a single production. Brad Pitt and Angelina Jolie bought a French Quarter mansion and enrolled their son in a local school while Pitt was making The Curious Tale of Benjamin Button, the biggest-budget feature ever filmed in the state. It had just wrapped in April and was set for a 2008 release.

The film biz was emerging as a bright spot in the region's patchy recovery. Kids I'd grown up with were returning home to take high-wage union jobs as electricians and costumers—the kind of story all too rare in NOLA. And LIFT Productions was at the center of it all: the largest production company around, with TV and independent films totaling $250 million in production budgets over just five years. LIFT was behind the recent Mr. Brooks and Bug, both with big Hollywood names attached. But even more impressive, from the perspective of the local economy, was LIFT's Film Factory—a planned 300,000 square-foot production facility. The groundbreaking had taken place the previous October, and the place was eventually to combine soundstages, postproduction, distribution, audio recording, and even a vocational film school. It would turn LIFT into a real studio—locally owned and operated—and cement the arrival of Hollywood South.

When I met LIFT's CEO, Malcolm Petal, that spring day, he was reveling in his role as mogul-in-the-making. His 31st-floor office on Canal Place commanded views of the French Quarter and the Mississippi Riverwalk. Short, muscular, and goateed, Petal was recumbent on the sofa in his reception area, summoning a masseuse. "We're trying to be a major international hub for film and television," he told me, "and we're off to a grand start."

Petal is a non-native New Orleanian, a Cornell grad and an attorney who'd been instrumental in jump-starting the local film biz by helping craft the new set of tax incentives designed to encourage investment. Petal himself had been swift to take advantage of those new credits, putting together $100 million worth of production deals with the newly formed LIFT and his college pal, Adam Rosenfelt, who ran another production company in California. When I met him, Petal was witty, sharp, and eager to expand on his complicated deals and leveraged investments. But the next day, a rainy Saturday, on the set of one of Petal's movies, I heard a different story. A crew member taking a smoke break pulled me aside, muttering, "Petal's being investigated by the FBI."

I didn't want the gossip to be true, turning my sunny New South business piece into another Louisiana cliché. But as I talked to more locals, the rumors thickened and darkened like a well-stirred roux. Larry Thomas of Film Services of Louisiana, in Clinton, came to the industry in the early 1980s as a dialect coach. ("For some reason, they thought ah could help them with their Suth'n dialects," he drawled slyly.) In March, Thomas told me, the FBI showed up asking about the state film office's financial relationships with the film industry. "I almost didn't answer the door—I thought they were Jehovah's Witnesses," he recalled. "I informed them of some roadblocks I had gone through with the state film office and sent them off with a pile of paperwork. The biggest thing I see is they [at the film office] have their pet people they seem to take care of more than they do others.... LIFT's been treated differently. I don't know why."

Louisiana's film tax credits can be converted into cash by being resold, usually at a discount, to an investor with local taxes to pay. The Times-Picayune reported in June that the Feds suspect LIFT of inflating production costs on at least two films—including Kevin Costner's Mr. Brooks, which was cleared for tax credits based on $34.1 million in expenditures, despite having a stated budget of less than $20 million. When the credits were first introduced in 2002, there was no independent auditing of expenses, and one person was principally responsible for signing off on production spending and converting it into credits: the state film commissioner, Mark Smith.

Smith left government last year to work for a film-industry firm. And in a May interview, he seemed to agree that lack of oversight of his office had been an issue. "I was working my butt off," he told me. "There were no accountants.... You don't want to put the responsibility of [auditing expenses] on the film office." But a civil lawsuit now parked in the 19th District Court alleges that an accountant shortage wasn't the problem: "There were illegal transactions taking place between [LIFT] and Smith in the form of money being given to Smith in exchange for his steering film and television production toward LIFT, and assisting and approving the acquisition of film tax credits for these companies."

Smith did not respond to requests for comment about the suit, while a lawyer for LIFT answered the allegations by telling me, "Whatever we did do is legal and was legal under the laws as they stood." But a lawyer for the state of Louisiana in the civil suit told me that "quite a number of individuals have signified their intention to plead the Fifth. This is going to impede the discovery of evidence in the case." Discovery will only be made more difficult by the fact that one of the people cited in the civil suit, Petal's former business partner, John Anderson, who claims to still own 44% of LIFT, is now telling reporters that he was "joking" when he told the plaintiff that there was a kickback scheme in place between Petal and Smith. It could be a long fall.

During our conversation, as Petal lolled on his couch, he described his operation as "very cooperative, transparent, and successful." By contrast, he depicted the rest of the local industry as something out of The Day of the Locust, full of the paranoid and delusional. Pausing to choose his words carefully, he said, "I'm not a psychologist, but as a layman it always seems to me that [people in the film industry] lack a certain sense of self-worth or identity.... A lot of people feel entitlement to careers in this industry. Not careers that they earned."

Six weeks later, on June 1, the FBI raided Petal's glass tower. Petal took a leave of absence and would not comment further to Fast Company; neither he nor Smith had been charged at press time. Over the summer, Louisiana's legislature passed a series of bills to close the loopholes and limit tax credits going forward. LIFT's credits were frozen, and in early July, it was announced that a newly formed company, Louisiana Production Resources, would be leasing or subleasing LIFT's film-production assets and employing its crews and staff.

But no cleanup is good enough if the business flees. "I don't think it will slow anybody from coming," said John Hardy, executive producer of Ocean's Twelve, from the New Iberia set of In the Electric Mist, starring Tommy Lee Jones. "It's just common sense that people will come here to save money." But with 46 other states now instituting some type of film tax credits, the fear is that the scandal will drive away future deals from Louisiana as quickly as they once flocked here. And the prospects of the big infrastructure projects, which could really support the local workforce and industry, are even more frustrating to contemplate. LIFT's Film Factory, with a $185 million estimated budget, had been the largest such proposal certified. Today, not a single bulldozer can be seen on the site, an empty lot in a neighborhood west of the French Quarter that is beaten down and blighted like so much of the city.

"This industry is smoke-and-mirrors sometimes," Mark Smith told me back in May. "I can touch it in New York and L.A.; I can see the headquarters and see who the real players are. In places like Louisiana, who can see it?"

That miragelike quality has always been part of the city, as endemic as beignets and dry rot. But as New Orleans crawls back from the biggest natural disaster in American history, there's just too much at stake to ignore the cost of our old habits. Politics as usual isn't enough anymore. "I believe that building a cultural economy is Louisiana's birthright," Petal said at his office. "The fact that the business side has never happened here is tragic." I couldn't agree more.

Feedback: kamenetz@fastcompany.com

A version of this article appeared in the September 2007 issue of Fast Company magazine.

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I just noticed this. I think it's very disingenuous not to mention that I sprained my back and was immobile. I wasn't exactly lolling. Not to mention that I forewarned you if you wanted to go forward with the interview I was incapacitated and would have to do it lying down.